Working Paper 202 - Segmentation and efficiency of the interbank market and their implication for the conduct of monetary policy

This paper assesses the role that bank segmentation plays in the efficiency of the interbank market and the extent to which segmentation and inefficiency of the interbank market impedes the effectiveness of monetary policy. Using a unique (not public) Kenyan daily dataset for the period June 2003 to September 5 2012 obtained from the Central Bank of Kenya (CBK), and utilizing network framework and event studies, the findings show that the Kenyan interbank market is incomplete, segmented and inefficient and this impedes monetary policy effectiveness in the short run particularly during periods of liquidity volatility. Evidence however shows that monetary policy is still effective in the long run, notwithstanding inefficiencies at the interbank market. However, this should not be any consolation for monetary policy makers since monetary policy is intended to work in the short to medium term. To improve the efficiency of the interbank and its role as a channel of transmitting monetary policy in such underdeveloped interbank markets like Kenya, monetary authorities must broaden the product tenors, increase the number of currencies traded, link the interbank with other money market segments and address counterparty risks.